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Copyright © 2004 South-Western
Supply, Demand, and Government Policies
Copyright © 2004 South-Western/Thomson Learning
Supply, Demand, and Government Policies
• In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
• While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.
• One of the roles of economists is to use their theories to assist in the development of policies.
Copyright © 2004 South-Western/Thomson Learning
CONTROLS ON PRICES
• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and floors.
Copyright © 2004 South-Western/Thomson Learning
CONTROLS ON PRICES
• Price Ceiling • A legal maximum on the price at which a good can
be sold.
• Price Floor• A legal minimum on the price at which a good can
be sold.
Copyright © 2004 South-Western/Thomson Learning
How Price Ceilings Affect Market Outcomes
• Two outcomes are possible when the government imposes a price ceiling:• The price ceiling is not binding if set above the
equilibrium price. • The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
Copyright © 2004 South-Western/Thomson Learning
How Price Ceilings Affect Market Outcomes
• Effects of Price Ceilings
• A binding price ceiling creates• shortages because QD > QS.
• Example: Gasoline shortage of the 1970s
• nonprice rationing• Examples: Long lines, discrimination by sellers
Copyright © 2004 South-Western/Thomson Learning
• In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.
• What was responsible for the long gas lines?
CASE STUDY: Lines at the Gas Pump
• Economists blame government regulations that limited the price oil companies could charge for gasoline.
Copyright © 2004 South-Western/Thomson Learning
CASE STUDY: Rent Control in the Short Run and Long Run
• Rent controls are ceilings placed on the rents that landlords may charge their tenants.
• The goal of rent control policy is to help the poor by making housing more affordable.
• One economist called rent control “the best way to destroy a city, other than bombing.”
Copyright © 2004 South-Western/Thomson Learning
How Price Floors Affect Market Outcomes
• When the government imposes a price floor, two outcomes are possible.
• The price floor is not binding if set below the equilibrium price.
• The price floor is binding if set above the equilibrium price, leading to a surplus.
Copyright © 2004 South-Western/Thomson Learning
How Price Floors Affect Market Outcomes
• A price floor prevents supply and demand from moving toward the equilibrium price and quantity.
• When the market price hits the floor, it can fall no further, and the market price equals the floor price.
Copyright © 2004 South-Western/Thomson Learning
How Price Floors Affect Market Outcomes
• A binding price floor causes . . .• a surplus because QS > QD.
• nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.
• Examples: The minimum wage, agricultural price supports
Copyright © 2004 South-Western/Thomson Learning
The Minimum Wage
• An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
Copyright © 2004 South-Western/Thomson Learning
TAXES
• Governments levy taxes to raise revenue for public projects.
Copyright © 2004 South-Western/Thomson Learning
How Taxes on Buyers (and Sellers) Affect Market Outcomes
• Taxes discourage market activity.
• When a good is taxed, the quantity sold is smaller.
• Buyers and sellers share the tax burden.
Copyright © 2004 South-Western/Thomson Learning
Elasticity and Tax Incidence
• Tax incidence is the manner in which the burden of a tax is shared among participants in a market.
Copyright © 2004 South-Western/Thomson Learning
Elasticity and Tax Incidence
• Tax incidence is the study of who bears the burden of a tax.
• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless of whom the tax is levied on.
Copyright © 2004 South-Western/Thomson Learning
Elasticity and Tax Incidence
• What was the impact of tax? • Taxes discourage market activity.• When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.
Figure 8 A Payroll Tax
Copyright©2003 Southwestern/Thomson Learning
Quantityof Labor
0
Wage
Labor demand
Labor supply
Tax wedge
Wage workersreceive
Wage firms pay
Wage without tax
Copyright © 2004 South-Western/Thomson Learning
Elasticity and Tax Incidence
• In what proportions is the burden of the tax divided?
• How do the effects of taxes on sellers compare to those levied on buyers?
• The answers to these questions depend on the elasticity of demand and the elasticity of supply.
Copyright © 2004 South-Western/Thomson Learning
So, how is the burden of the tax divided?
• The burden of a tax falls more heavily on the side of the market that is less elastic.
ELASTICITY AND TAX INCIDENCE
Copyright © 2004 South-Western/Thomson Learning
Summary
• Price controls include price ceilings and price floors.
• A price ceiling is a legal maximum on the price of a good or service. An example is rent control.
• A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.
Copyright © 2004 South-Western/Thomson Learning
Summary
• Taxes are used to raise revenue for public purposes.
• When the government levies a tax on a good, the equilibrium quantity of the good falls.
• A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
Copyright © 2004 South-Western/Thomson Learning
Summary
• The incidence of a tax refers to who bears the burden of a tax.
• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
• The incidence of the tax depends on the price elasticities of supply and demand.
• The burden tends to fall on the side of the market that is less elastic.